(Bloomberg Opinion) — Half of Americans aren’t saving enough for retirement. Blame for this problem is usually pinned on some combination of low wages or irresponsible choices, but there’s another culprit: an expensive and antiquated 401(k) system. Reforming it could put billions more dollars into savers’ pockets.
Our current system favors costly middlemen in ways that were perhaps necessary when 401(k)s were first established 40 years ago, but are largely superfluous today. Consider that by various estimates, the average fees levied on 401(k) savings hover in the range of 0.5% annually, with much higher costs for small employers. That compares to annual expenses well under 0.1%, and often near zero, offered by widely available stock and bond index funds and ETFs in many flavors and stripes outside of 401(k)s.
That excess cost — roughly 0.4% annually — may not sound like much. But for a worker who dutifully puts $10,000 a year for 40 years into a portfolio that earns 6% annually, the difference in final savings can be north of $150,000 — greater than 10% of the end sum.
With more than $5.5 trillion invested in 401(k) plans, cutting costs to savers by even 0.4% would add more than $20 billion annually to the nest eggs of American workers.
I recently got a glimpse of the damage that expensive fund offerings can do to 401(k) savers. A close friend asked me to look at the plan he’s been investing in for 20 years. Instead of cheap index funds, the plan offers a menu of high-priced (and underperforming) actively managed vehicles. Its only index-tracking choices are expensive “collective investment trusts” costing about 0.5% more than index mutual funds and ETFs. Even more outrageous? The trusts allow their sponsor to make even more money by lending out the securities that it holds.
Over two decades, the excess fees have likely cost him about $25,000, or about 5% of his $500,000 retirement stash. Any of his colleagues who invested in the active funds gave up significantly more — thanks to higher fees and worse performance.
To cut costs and ensure that workers retain every penny of their 401(k) savings, policy makers should simply eliminate 401(k) intermediaries. Let American workers save for retirement using their choice of designated, IRA-like accounts offering the same, cheap index-tracking funds and ETFs available outside of retirement plans. All the other incentives that encourage Americans to save through their 401(k)s could be maintained, including preferential tax status, employer matching contributions and enrolling employees by default. Depending on how heavy a regulatory hand one prefers, retirement accounts could even be required to hold a diversified portfolio to qualify for tax benefits and employer matching.
There’s plenty of precedent for a better, cheaper approach to saving. For example, take the 529 plans sponsored by states. New York’s 529 plan offers a range of index and age-based fund choices, many with expenses as low as 0.13%.
As an added bonus, employers would no longer have to spend time and money establishing and monitoring their own, costly 401(k) plans. And employees of small businesses would no longer face a cost disadvantage vis-à-vis the plans offered by large firms, as they do today.
Any effort to reform the current, middleman-heavy 401(k) structure will no doubt bring howls of opposition from the investment management industry. Their most likely argument will be that investment managers and trustees perform a useful function in providing optimal investment choices, while educating savers on how to select among them.
The evidence debunks those arguments. For example, research conducted by Yale Law School Professor Ian Ayres and University of Virginia Law Professor Quinn Curtis suggests that most 401(k) participants don’t allocate their investments efficiently, meaning that for any degree of risk, 401(k) savers are getting sub-optimal returns out of expensive funds dominated by offerings from fund sponsors. If investment managers’ role is to educate 401(k) participants on how best to choose a diversified portfolio, they’re doing a pretty poor job of it.
Forty years ago, cheap index mutual funds were in their infancy, information was delivered in the mail, and investments had to be directed via pen and paper. In such an opaque world, employees arguably needed employers, intermediaries and fiduciaries to help them select the best mix of investments for retirement.
The financial system is now vastly more efficient, liquid and transparent. A broad consensus exists around the benefits of low-cost, diversified index funds for most retail investors. It’s time to reform 401(k)s, cut out intermediaries and take the burden off of employers, so that workers can enjoy every penny of their hard-earned savings.
To contact the author of this story:
Ethan Schwartz at [email protected]